Description

Recent Developments

The following write-up was submitted as an application to VIC on July 15th, however I was not approved to post the idea for members until now. Several significant developments have occurred since mid-July which are important to mention up front:

• The company announced a stock repurchase program of $75 million which represents about 15% of shares outstanding

• Q2 earnings were released:

• 2015 revenue guidance was raised from 0 to -4% to 0 to -3%

• Total revenue increased $10 million sequentially

• Consumer revenue increased $2 million sequentially

• Enterprise revenue grew $3 million sequentially

• Excluding TDM disconnects, which should trough in Q4, the Carrier segment showed slight growth year over year.

• SMB revenue was down $5 million sequentially.  This is now the only remaining business segment yet to show signs of stabilizing

• The company signaled that they may begin purchasing portions of their outstanding debt currently trading at a discount

• The company elected to receive $175 million in CAF 2 funding each year for the next 7 years thereby increasing their net cash receipts from the government by $75 million per year.  They will receive $95 million in cash payments this year as a true-up payment, $60 million of which will come as a single payment in Q3.

• Beginning August 31st and continuing through the end of the year, the company will begin rolling-out the largest high-speed internet upgrade in its history, delivering speeds of between 50 and 100 Mbps to one million new locations and to 1/3 of their existing high speed internet base. This development is made more significant by the fact that the consumer business segment, which these new speeds are targeting, has shown top-line stability over the last few quarters even before this speed introduction. To quote Bob Gunderman, CFO of Windstream: “We are now at the cusp of being able to sell high speed internet in a way that we never could before.”

Introduction

Windstream Holdings is a highly liquid, severely mispriced, and heavily shorted telecom company whose recent spin-off of network assets into a publicly-traded REIT (CSAL) led to massive confusion and uncertainty among existing and prospective shareholders, and a more than 50% decline in the company’s stock from its first day of trading only three months ago. As part of the spin-off, Windstream transferred approximately $3.4 billion of debt to CSAL, and also retained 29.4 million shares of CSAL as an asset, which it intends to monetize within the next 18 to 24 months. The company intends to use the proceeds from this monetization to retire additional debt thereby making the total debt reduction from this transaction well over $4 billion.

Although hard to believe, Windstream is now trading at a multiple of between 1 and 1.7 times FCF (depending on your FCF assumptions) and has an EV to EBITDA ratio of 4.31, which is inexplicably low relative to its peers given the company’s low level of debt (3.7x EBITDA after selling CSAL stake) and the stability of its cash flow.  It has $5.7 billion in revenue, $1.3 billion in EBITDA, and currently generates at least $330 million in after-tax FCF, soon to increase even further through a secured debt restructuring saving $50 million in interest expense (see “Secured Debt Refinance”).  Finally, Windstream pays an annual dividend of 60 cents, now yielding 10.6%, which is so small relative to the company’s cash flow and capex budget that there is no realistic chance of a cut in the foreseeable future (see “Sustainability of Dividend”). Looking closely at each of the company’s business segments one sees that the underlying problems responsible for the deterioration in revenue and EBITDA margins have since been rectified or alternatively, as in the case of wireless TDM, will shortly have run their course (see “Prospects for the Business”).  The company’s core business is stable and should show sufficient growth in 2016 to offset the last remaining step-downs in ICC switched-access reform and the temporary declines from wireless TDM disconnects. Both revenue and EBITDA may decline slightly through the end of the year, however the valuation at these levels is compelling enough to justify taking a position before the turn-around becomes obvious, especially given Windstream’s attractive and sustainable dividend.

But before digging into the details, let’s first pay a quick visit to those hard-to-believe, big-picture valuation measures:

Shares Trading for 1.0 to 1.7 x FCF

Windstream announced a capex budget of approximately $850 million for 2015, of which management claims (adamantly) that only $425 million is required for maintenance of plant and equipment while the remainder is actually discretionary FCF that has been temporarily allocated to capex for the purpose of stabilizing and growing parts of their business. They claim that without allowing any portion of their network to deteriorate they could reallocate up to $425 million a year for debt pay down, stock buy-backs, or dividends, and still provide the same quality service to their customers that they do today.  Since this is such an important point I should pause here momentarily to back-up this claim. In an email to me on Friday, July 3rd, the company had the following to say:

“Regarding our capital budget for 2015, we have said that we expect to spend the following amounts, which are going toward initiatives rather than just maintaining our current plant:

• $95m in CAF-1 investments (Connect America Fund 1),

• $30m in incremental IT spend on projects to drive efficiencies

• $30 -$40m in data center expansion

• $75m in broadband capacity and speed enhancements

• roughly $100-150m in success based carrier and enterprise investments

• $20m in fiber expansion to displace interconnection costs

While there are other discretionary or initiative capex dollars in our budget, these are good examples that add up to about half of our total budget.”

Now, assuming these dollars are truly discretionary, and if you believe that Windstream’s EBITDA will be stable or growing in the near future (see “Prospects for the Business”), you could make the argument that Windstream not only has the $58 million in un-allocated FCF they discuss on page 8 of their Barclays presentation of June 11, 2015, nor also the $60 million that is currently being used to pay the 10.6% dividend, but also an additional $425 million that is temporarily being applied to capex to stabilize the business and support future growth.  True FCF for Windstream would then be $58 million + $60 million + $425 million, or a total of $543 million.  At a market cap of $564 million this Friday, August 7th, the company would then be trading for about 1x FCF.

The more conservative approach, and the one I am most comfortable with from a valuation perspective, is to make the argument that a certain amount of capex must be spent each year, in excess of maintaining existing plant, in order to remain competitive in an environment with changing technology and fierce competition.  However, that number is still nowhere near $425 million, which would imply a doubling of the capex budget over what is required to maintain the entire existing infrastructure. Suppose half of the $425 million is needed to remain competitive over the long run. That still leaves Windstream with FCF of about $330 million, meaning the company would still be trading at a multiple of only 1.7x FCF.

But to fully illustrate how inexpensive Windstream has become even in the current environment of slightly declining EBITDA – a situation I will argue is imminently reversible – let’s imagine an unrealistic scenario in which management cuts their capex budget from $850 to $300 million for just a single year. With this one-time cut of $550 million, which is a reduction in capex spending of 65%, they would save enough cash to buy back all of their outstanding shares in only 1 year.  If CenturyLink (CTL) were to cut by the same percentage, it would take 8 years to buy back their outstanding shares. In the case of Frontier (FTR), it would take them almost 14 years (see Table 1 below).

EV to EBITDA ratio 4.31x

The low end of EV to EBITDA ratios for WIN’s peer group, including such players as CTL, FTR, CBB and CNSL is approximately 5.5x.  Windstream on the other hand is currently trading at a multiple of 4.31x.  There is nothing so worrisome about Windstream’s business that it justifies such a draconian valuation with respect to its peers.  Windstream is suffering from the same set of business concerns that every other player in the group is suffering from:  competition from wireless and cable, wireless TDM disconnects, and switched-access reform.  In fact it could be argued that Windstream is in a better position to combat these issues than many of its peers due to its low dividend to capex ratio, its low debt, and the fact that its customer base is almost entirely rural, making it uneconomic for its competitors to build the infrastructure necessary to support high-speeds in its territory.  If Windstream were to trade at just the low end of its peers in the industry, its stock price would be at least $21, a gain from here of more than $15 per share, or nearly 300%.

Here is the math:

Consensus Ebitda estimate 2015.............$1.29 billion

Net debt...................................................$5.64 billion   

Monetization of stake in CSAL at $22.......$647 million    ($22 x 29.4 million shares)

Market Cap...............................................$564 million    ($5.64 x 100 million shares)

Enterprise Value.......................................$5.56 billion    ($5.64 B – $647 mil + $564 mil)

Current EV to EBITDA ratio........................4.31x

At an EV to EBITDA ratio of 5.5x:

$1.29 billion EBITDA x 5.5 multiple........= $7.10 billion

Subtract net debt of $5.64 billion..........= $1.46 billion

Add CSAL stake at $647 million..............= $2.11 billion

Divided by 100 million shares.............= $21.10 per share

It should be noted that $22 per share is an ultra conservative estimate for the sale of CSAL in the enterprise value calculations above.  The likelihood of CSAL actually being monetized at $22 per share is very low. Windstream has 24 months from the date of the spin-off in April to complete the sale of their 20% stake (to retain tax benefits) and they have indicated on several occasions, including the last conference call, that they intend to wait until CSAL is fairly valued before going to market.  CSAL pays an annual dividend of $2.40 per share and is currently trading with a yield of 11.3% in a REIT market where yields for similar triple-net REITS are trading in the 5% to 7% range (see Table 2 below). Clearly, there is substantial upside for Windstream shareholders if CSAL trades back in line with its comps. For example, if CSAL were to trade with a yield of 7.75%, still at the high end of its comps, the stock would be $31 per share where it traded only a few months ago, and would provide an additional $285 million in debt reduction for Windstream - an increase in value to Windstream shareholders of $2.85 per share.

There has been some discussion over whether one can use EV to EBITDA ratios to compare Windstream to its peers post-spin since it is now primarily a company that leases its network distribution assets rather than owns them.  Although I prefer looking directly at FCF, I still think it makes sense to compare the companies using this traditional method. The reason is that most of the companies in the industry lease some portion of their network in the form of IRU’s (Indefeasible Rights of Use), which is essentially the same structure that Windstream has created with CSAL. Yes, Windstream leases a much larger portion of its assets than CTL or FTR but it also has a much longer lease term (35 years) than traditional IRUs of only 10 to 20 years.

The other issue actively being debated is whether Windstream’s lease arrangement with CSAL should be treated as an operating lease or a capital lease for purposes of determining enterprise value and calculating EV to EBITDA ratios.  Again, I prefer using the FCF method of valuation. But if you’re going to use EV to EBITDA ratios, it is worth keeping in mind that, despite being treated as debt for GAAP accounting purposes, 14 of the largest banks in the world regard Windstream’s lease as an operating lease, and it is not defined as debt under any of their indenture or credit agreements.  For tax purposes it is also being treated as an operating lease.

Secured Debt Refinance to Provide $50 million in Additional FCF

The company currently has a secured leverage ratio of less than 1x EBITDA whereas they are allowed 2.25x EBITDA under their bank credit agreements, allowing them total secured debt of about $2.9 billion.  This gives them the flexibility to issue term loans at just over 3% to repay existing unsecured debt up to a total of about $1.1 Billion. With an interest savings of 4.5%, this would add an additional $50 million to FCF annually. In conversations with management, it is clear that executing on this opportunity is high on their list of priorities.

A common misconception is that Windstream transferred more than 80% of their assets to CSAL and that they have few assets remaining to secure new debt. In fact, Windstream transferred fewer than 25% of their assets. They did transfer nearly 80% of their copper and fiber distribution assets, but the vast majority of their other assets remained with the company.  The rest of their network, consisting of electronics, equipment and the 20% of fiber distribution assets not transferred to CSAL, make up a substantial part of the security package for their lenders. According to the company, there is still enough security available to refinance an additional $1.1 billion.

In fairness, it should be pointed out that the sale of Windstream’s 20% CSAL stake at current prices ($21.26/share), while generating $625 million in cash for debt pay down, would actually subtract from FCF slightly. The reason for this is that the dividend they are receiving from CSAL ($72 million) is greater than the interest they will save by paying down $625 million in debt at 7.875% (about $50 million). However, Windstream has now stated publicly several times that they believe CSAL is significantly undervalued and that they do not intend to monetize their 20% stake at these levels. In fact, based on conversations with both CSAL and Windstream, it appears management may be waiting for CSAL to complete a second sale-leaseback transaction with another carrier, similar to the one they just completed with Windstream.  This should bolster the price of CSAL stock as it would then be apparent that CSAL no longer depends on a single tenant.  While it is most likely that CSAL (itself ridiculously undervalued with a yield over 11.3%) will not be sold for less than $850 million, I will be ultra-conservative in the cash flow projections below and assume the stake is sold at current prices.

So, what is WIN’s true FCF, after all these transactions are completed, and assuming EBITDA is stable?

(in millions)

Consensus Pro Forma EBITDA 2015.............................$1290        *Pro forma for spinoff

Dividend from CSAL.........................................................$72

Subtotal.......................................................................$1362

Sale of CSAL stake:

    Interest saved on $625 mil debt pay-down..................$50

    Loss of dividend payable by CSAL...............................($72)

Cash Taxes......................................................................($20)

Cash Interest before refinance.....................................($375)

Interest savings on refinance of $1.1 billion in debt........$50

FCF before Capex............................................................$995

Maintenance Capex......................................................($425)

Pro Forma FCF............................................................... $570 million    *Pro forma for CSAL sale & refi

Bear in mind, we are currently trading at a market cap of $564 million.

Sustainability of the Dividend

Notwithstanding comments by some sell-side analysts and the precipitous decline in Windstream’s stock, the company is flush with liquidity and in no danger of having to cut its 60 cent dividend, now yielding 10.6%.  Even if we exclude from FCF the $425 million they are temporarily allocating to capex, Windstream still has about $118 million in excess FCF to meet the dividend payment (see calculation below), and will have nearly $170 million in excess FCF to meet the dividend payment once they complete the refinancing of $1.1 billion in high interest rate debt. Even if you assume that EBIDTA declines by $50 million in 2016 (see “Prospects for the Business”), which is at the very high end of estimates, and assumes no growth in any of the currently growing business segments, Windstream would still have nearly $120 million in FCF to cover their $60 million dividend.  Finally, if on top of a worst-case scenario for EBITDA, Windstream were also to sell their CSAL stake at $22 per share and thereby gain less in interest savings by retiring debt than they would lose by forfeiting the $72 million dividend (a difference of $21 million), the company would still have nearly $100 million in excess FCF to meet the dividend payment.  This assumes no reduction in the elevated levels of capex currently being spent nor any FCF benefit they might receive from the $179 million in CAF II funding currently being offered by the government.

(in millions)

2015 Pro Forma EBITD...............$1291

Dividend from CSAL.......................$72

Cash Taxes...................................($20)

Cash Interest..............................($375)

FCF before Capex.........................$968

Maintenance Capex....................($425)

Initiative Capex...........................($425)

FCF available for dividend............$118    *Currently available to pay the dividend

Interest saved - $1.1B debt refi......$50    *Coming later in 2015

FCF available for dividend............$168 million

Furthermore, Windstream’s $60 million dividend is only 7% of its $850 million capex budget for 2015, which is by far the smallest ratio of dividend payment to capex expenditures of any of its peers (see Table 3 below). Contrast this with CTL whose dividend payment is 41% of its capex budget or with FTR whose dividend payment is 72% of its capex budget.  Why is this important?  Because even if for some unimaginable reason Windstream’s $168 million in excess FCF were to disappear, it is hard to believe management could not repurpose some portion of their $850 million capex budget in favor of the dividend payment given their numerous, adamant statements that 50% of their capex is discretionary, and their hyper-low dividend to capex ratio of 7%.  In sum, unless business conditions change radically, the dividend is safe.

Prospects for the Business

Windstream primarily operates in rural America, in towns with populations of 5000 people or less.  Its largest markets, as the company is quite fond of reminding us, are Lincoln, Nebraska and Lexington, Kentucky, with populations of 270,000 and 310,000 respectively. This gives them a significant moat around their business since for most cable operators, wireless carriers, or telecom operators it does not make economic sense to invest significant amounts of capex to bring fantastically high speeds into Windstream’s markets. In fact, as we will see below, Windstream is positioning itself to provide the highest access speeds in nearly all of its territories.  The company’s business is divided into several segments:  Consumer, Small & Medium Business (SMB), Enterprise, Carrier, and Regulatory. Let’s examine each of these individually to see where revenue and EBITDA margins are likely to trend over the next 12 months.

Consumer Segment

Windstream’s consumer segment has revenue of $1.3 billion and consists of high speed internet, video and voice offerings to residential households. It is divided into two sub-segments:  ILEC and CLEC.  The consumer CLEC business was transferred to CSAL as part of the spinoff so we will ignore this segment.  However, the ILEC business, which represents those residential customers who are entirely “on net”, meaning they are situated directly on the Windstream network rather than being linked through leased lines, is a priority for Windstream, with high EBITDA margins of 60-70%, and has been receiving substantial investments to its infrastructure over the last several quarters.  In the consumer segment, the largest competitors are the wireless companies, who have been supplanting, and continue to supplant voice lines, and the cable companies who offer broadband at high speeds and competitive prices. Until recently, Windstream has been providing broadband access using DSL over its copper infrastructure, which limited available speeds to 10 Mbps and under. Cable was able to gain considerable market share by offering much higher speeds at discount prices. To compete, Windstream became the low cost provider, offering super-discounted pricing at low end speeds to attract those value-oriented customers who didn’t need the higher speeds that cable was offering.  This strategy enabled them to remain competitive but at the cost of receiving lower margins on a gradually dwindling customer base.

To change the competitive landscape, Windstream began rolling-out VDSL+ to nearly all of their residential customers in 2015, which will allow them to offer speeds up to 75 Mbps, equaling or exceeding those of cable (see p.8, Q1 presentation, May 7, 2015).  The only customers not receiving the VDSL+ upgrade are the 7% who live in areas too remote to provide high-speed access cost-effectively.  By the time the roll-out is complete later this year, more than 50% of Windstream’s customers will have access to speeds over 25 Mbps compared to 18% before the initiative, dramatically changing their competitiveness with respect to cable.

Even before the roll-out of VDSL+, tremendous progress has been made stabilizing the consumer segment. A year ago, Windstream was seeing year over year revenue declines in this segment of 3 to 4 percent.  By comparison, revenue in the last few quarters has been nearly flat, which shows stabilization of the consumer business even before the impact of higher speeds that are currently being brought to market. With the installation of VDSL+ well underway, management seems confident that the consumer segment is turning the corner and is poised for growth in 2016.

Small & Medium Business (SMB)

The SMB segment was recently redefined to include all business customers with monthly recurring revenue of less than $1500.  The segment generates $1.02 billion in annual revenue and is divided into two sub-segments:  the CLEC business, which represents $584 million in annual revenue, and the ILEC business, which represents about $432 million.  EBITDA contribution margins on the CLEC side are in the mid to low single digits whereas margins on the ILEC side are 60-70%. In both segments, the primary competition is cable, which is well-positioned to be a serious competitor. In the CLEC segment, margins are low because Windstream must not only lease access lines from other carriers to provide service but must also offer the service at an ultra-low price to compete with the higher speeds offered by cable.  Revenue in this segment is declining in the low double digits although the negative impact to EBITDA is light due to the low margins, at about $5 million per year. Management is focused on improving margins in the CLEC segment by improving efficiency, reducing costs and selling incremental services.

The ILEC segment is much more promising.  As in the consumer ILEC segment, Windstream owns the network that provides access to all their customers so EBITDA contribution margins are higher, at about 60-70%.  In addition, they are upgrading the plant with the same VDSL+ improvements that are being made in the consumer segment.  In fact, management has decided to combine the SMB ILEC segment with the consumer ILEC segment for marketing and servicing purposes as these customers are essentially the same.  In the ILEC SMB segment revenue has been declining in the low single digits due to intense competition by the cable companies who until recently could provide much faster speeds at discounted prices.  However, by upgrading their entire network with VDSL+ and thereby providing speeds between 25Mbps and 75Mbps to over 50% of their customers, management is hoping to see stability in this segment toward the end of this year and growth in 2016.

Enterprise segment

The Enterprise segment consists of those business customers who spend between $1,500 and $100,000 per month on internet, telecom and managed network services. Although a highly competitive space, this segment is growing in the low single digits with revenue of $1.9 billion and EBITDA contribution margins in the teens. Market share is relatively low so growth should continue for some time.  Currently, a large number of Enterprise customers are connected to Windstream’s network via leased lines from other carriers. In a bid to improve margins, Windstream is aggressively overbuilding these leased connections with fiber and cancelling the leases, a program that is slated to continue through 2020. For every 100 bps of margin improvement that they achieve in this segment the company gains $23 million in EBITDA.

Although the Enterprise segment appears to be doing well, there are lingering concerns among investors that cable companies will become as much of a competitive threat in the Enterprise space as they have in the consumer and small business space. This is unlikely to be the case.  According to management, the technological competitive advantages that cable has on the small end do not exist at the Enterprise level.  Windstream has advanced fiber optic networks that can offer speeds as fast as any of its competitors, and in most cases much faster.  In addition, where Windstream truly has the upper hand is in its ability to manage large complex networks without interruption.  The Enterprise space may not be a barn-burner, but it should provide reliable growth and solid to improving margins for the foreseeable future.

Carrier Services

The Carrier Services segment consists of backhaul and transport services sold to other carriers, most importantly wireless carriers. It also consists to a smaller extent of revenue from companies that are wholesaling or private-labeling Windstream products.  Backhaul and transport represent about $505 million per year in revenue whereas wholesale represents about $124 million. Wireless TDM makes up the difference at $66 million.  Starting in 2011, Windstream invested nearly $2 billion in fiber connections to wireless towers to replace old copper connections. Although these investments have yet to show stellar returns, management believes this is a huge opportunity for the company that has not yet been fully realized. Carrier Services as a segment has been declining at about 7% per year, ironically as a result of the same investments that will eventually make this space a significant source of future growth. As high-capacity fiber was connected to wireless towers, wireless operators no longer needed to pay for multiple T-1 connections at these locations and began disconnecting them. This led to a reduction in revenue for Windstream since multiple T-1 lines produce more combined revenue than the leasing of a single fiber cable. This migration from copper to fiber has single-handedly been responsible for the revenue declines in this high margin segment and a substantial portion of the company’s lost EBITDA, however it has very nearly worked itself through the system. If you remove the wireless TDM pressure that’s been in the carrier segment for the last three quarters, the rest of the segment showed growth in the low single digits. Furthermore, the company is making substantial investments in their long-haul network which should help boost growth in future quarters.  Management seems certain that wireless TDM disconnects will run their course by the end of this year and that the Carrier segment will start to show growth in 2016.  With margins of approximately 80% this segment will eventually become a significant driver of future profitability.

Regulatory and other  (previously “Wholesale”)

Now for the real dog. The Regulatory segment contains the ICC switched access business with 2014 revenue of $166 million and 100% EBITDA contribution margins, which is declining in the mid-teens and will continue to decline for the foreseeable future. Government-mandated step downs in the interconnect fees that carriers are allowed to charge one another will eventually erode most of the revenue in this segment. At the end of the step-downs, carriers will be required to reduce their interconnect fees to zero and to recover the lost revenue, if they can, by increasing charges to their own customers. Management recommends modeling the decline in this segment at about 15% per year, for this year and next, although the last of the major step downs occurs this year.

Unfortunately, there is additional revenue in the Regulatory segment that is also going away. As part of the government program to reduce interconnection costs to zero, the affected carriers were given temporary grants on an annual basis, known as ARCs and ARMs, to soften declines in revenue due to the mandate.  In Windstream’s case, this amount was roughly $50 million annually at the end of 2014 and will step down to zero over a period of 5 years.  Finally, state USF support of $117 million is also under pressure.

There is however, one additional ACE in the deck…

Connect America Fund (CAF II)

Traditionally part of the Wholesale segment (now renamed “Regulatory and other”), CAF II is a government-sponsored program which provides network-expansion grants of considerable size to companies who provide service in rural communities. Windstream, of course, is one of the largest providers of these services and was recently offered $179 million in grants by the government each year for a period of 7 years. In exchange for this payment, Windstream must guarantee a minimum speed of 10 Mbps to a specified number of people in each of several census blocks. The company has until the end of August to review the government’s proposal and determine how much of this $179 million/year offer they will accept and for which census blocks. From managements’ comments on conference calls and in live presentations, it appears they will most likely accept most of the funding offered. In Windstream’s case, management says, they have already provided broadband speeds of 10 Mbps or greater to large portions of the census blocks offered to them so the additional expense necessary to meet the government’s targets are insignificant in many areas.

Looking on page 17 of the first quarter 2015 earnings presentation, we see that total USF Support amounted to $267 million in 2014. Of this amount, $100 million was Federal USF support, just over $117 million was State USF support, and approximately $50 million is tied to the switched-access mandate as mentioned earlier. The new block of funding from the Federal government, known as CAF II, will replace the existing $100 million in USF Support, while the State USF support of $117 million will remain unaffected. Therefore, if Windstream accepts the full $179 million in new grants from CAF II, they will gain an incremental $79 million in funding per year.  The funding from CAF II is taxable, however with Windstream having $1.3 billion in NOLs, this amount will flow entirely to the bottom line.

If Windstream accepts the CAF II funding before September there is also the possibility that they will receive a retroactive payment of $60 million for calendar year 2015. This payment represents 9/12ths of the difference between the $100 million currently being provided annually under the Federal USF program and the new annual payment of $179 million under CAF II. If the grant is completed by the end of September, the government would owe Windstream an additional $79 million for the entire year and would send the company a true-up payment equal to 9/12ths of $79 million, or $60 million, to cover CAF II from January through September of this year.

How would this affect FCF for 2015 and beyond?  Going back to management’s email on July 3rd, the line item for CAF I projects shows a capex allocation of $95 million.  According to the company, this item will not repeat in 2016 or later regardless of whether CAF II is accepted or not. However, if CAF II is accepted, the company says that capex spend on CAF II projects will be approximately equal to the amount granted.  If Windstream accepts the full $179 million in support offered to them capex spend for CAF II will then be approximately $179 million. The end result is that the company replaces $95 million in capex currently being spent by the company with no offsetting support, with $179 million in annual capex that is entirely funded by the government.

Business Prospects - The Bottom Line

The year over year pressure on revenue and EBITDA margins have come primarily from two areas: the last remaining step-downs in the ICC switched-access reform and carrier wireless TDM disconnects. Those segments make up 150 basis points of Windstream’s margin pressure year over year. While TDM disconnects will come to an end later this year, allowing the carrier segment to start growing, the switched access business will continue to be a drag for many quarters to come. It will however, become less and less of a drag as time goes on. Prospects for the CLEC SMB business on the other hand are unknown at present but the impact to EBITDA is low given margins in the mid to low single digits.

However, every other segment of Windstream’s business should be stable or growing into 2016. The consumer segment is stable and poised for growth later this year.  The ILEC SMB segment should stabilize and show growth in late 2015 or early 2016, particularly in light of the investments being made in high-speed VDSL+.  Enterprise is growing nicely in the low single digits, with margins in the teens; and Carrier, excluding TDM disconnects which will subside later this year, is showing signs of growth.  By the end of this year, it is hard to see how management would not be able to guide for stable EBITDA in 2016 with the possibility of growth.

30% of Shares Short

As discussed above, Windstream’s revenue and EBITDA should stabilize between now and 2016, possibly showing growth in 2016. Furthermore, Windstream stock is so cheap that it generates enough FCF in only 1 or 2 years to buy back its entire float at current prices.  Despite these facts, Windstream is home to short positions totaling nearly 28 to 30 million shares, which is 30% of the total shares outstanding. The bear case is fairly simple: growth in the enterprise, carrier, SMB ILEC and consumer segments fail to offset declines due to switched-access reform and CLEC SMB, leading to a decline of $50 million in EBITDA for 2016.  The decline in EBITDA is sufficient to jeopardize the company’s dividend, the bears argue, and the company is forced to eliminate it.  This argument is highlighted in Batya Levi’s July 13th comment on Windstream (price target $5), which sent the stock plummeting from $5.68 to nearly $5.00 in one afternoon.  Needless to say, given my earlier analysis of the sustainability of the dividend and the likelihood of upcoming stability in EBITDA, I wholeheartedly disagree with this interpretation.

A Note on Cash Taxes

Cash taxes for 2015 are projected to be approximately $20 million and, according to the company, should remain very close to this figure for at least the next few years. The transaction with CSAL gives them a tax-deductible lease payment, allowing Windstream to extend the use of its $1.3 billion in NOLs, which only expire in varying amounts between 2022 and 2031. Furthermore, if they are able to take advantage of the bonus depreciation provisions in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act, as they have every year for the last 8 years, the use of these NOLs can be pushed out even further.

Why this Opportunity Exists

In April of this year, Windstream completed the spin-off of its telecommunications network assets, consisting of approximately 75-80% of its fiber and copper networks as well as other real estate, into Communications Sales & Leasing, Inc. (CSAL), a publicly-traded Real Estate Investment Trust. This was the first such transaction of its kind in the telecommunications space and has generated massive confusion and uncertainty among existing and prospective shareholders. Even sell-side analysts who have been following the company for years seem perplexed at how to properly value the company, opting instead to tailor their valuation methods to arrive at a price that mirrors the current market price of the stock.

Below is a list of reasons (probably not complete) why Windstream plummeted from $12 post-spin to nearly $5 today:

1. Prior to the spin-off, Windstream had the highest dividend yield among any of its peers, yielding at times just below or just over 10%. As a result, it attracted an enormous following of dividend-seeking investors. Once the spin-off of CSAL occurred, the combined dividend payout of CSAL and WIN was cut from $600 million to $348 million - a decline of 42% - and most of these investors sold.

2. For the average investor, and for many institutional investors as well, the complexity of the transaction and the uncertainty over how the market will ultimately value the parent company post-spin has led to massive selling by existing holders and caused many institutional investors to sit on the sidelines. For example, in conversations with some of my institutional friends, the following concerns were raised, just to mention a few:  For valuation purposes, will the market regard the payment of $650 million to CSAL as an operating lease or a capital lease?  Can one still use EV to EBITDA ratios at all when comparing WIN to its peer group, now that Windstream is leasing the bulk of its network, or do we need to look at some other measure?

3. Concerns over the stability and direction of the business. Current guidance for 2015 is for revenues to fall between 0 and 4%.  To understand why this is the case and when these declines might reverse requires a detailed analysis of each of Windstream’s business segments. This is a daunting process that for most investors requires hundreds of hours of work and many conversations with management. In light of the declining revenue and EBITDA numbers, most investors simply chose to sell.

4. Concerns about the fact that Windstream no longer owns its network, how this will affect its future plans for expansion, who owns any improvements that are made, and whether anyone would ever be interested in acquiring such a company.

5. A few weeks following the spin-off, with the stock already down 33%, Windstream was unexpectedly dumped from the Midcap 400, after having been placed in the same index only a few weeks before. This, of course, generated selling by index funds, and a new round of selling by panicked investors.

6. Absence of easy-to-understand post-spin financial statements.  The absence of a clean set of financial statements post-spin has made it extremely difficult to understand the story without extensive conversations with management and a lot of financial reverse-engineering. Very few people will bother.

7. Massive declines in the sector – particularly in the stocks of CTL and FTR

8. July 13th downgrade by UBS analyst Batya Levi to ‘Sell’ with a price target of $5 citing continued deterioration in the business, lower debt reduction due to slippage in CSAL stock price, and potential inability for WIN to meet their dividend payment.  This report is worth reading as it illustrates the bear case in the story quite compellingly.

9. And finally, but certainly not of least importance, Windstream stock has fallen more than 50% in a period of only 54 trading days on absolutely no news.  During this time the stock has traded an unbelievable 360 million shares – almost 4 times the number of shares outstanding – and continues to post volume of 3 to 7 million shares per day. There have been ten days in which the stock traded 10 million shares or more, again on no news, and two periods during which the stock went straight down, without a higher close, at least 9 days in a row. This rapid and unrelenting decline terrified many investors, even those who thought they understood the story, leading many to sell.

Catalyst

Catalysts

1. Stabilization of the business. By year end, we should see evidence that wireless TDM disconnects have come to an end paving the way for growth in the Carrier segment.  We should also see signs of growth in the Consumer segment and the ILEC SMB segment where the company has been making substantial investments.

2. Year-end revenue guidance for 2016 of flat to slightly positive growth combined with guidance for improving margins.

3. 2015 results could surprise to the upside. This might occur if a substantial portion of the $179 million in CAF II funding is able to be booked as revenue. Management has said this is a possibility. We should know sometime in Q3.

4. The completion of the sale of Windstream’s 20% interest in CSAL, which will allow them to pay down another $650 million to $850 million of debt.

5. Completion of the refinancing of $1.1 billion in high interest rate debt, which should occur later this year using Windstream’s remaining secured leverage. As mentioned earlier, their secured leverage stands at less than 1x EBITDA whereas their covenants allow for 2.25x EBITDA.  This is a significant management focus and will generate $50 million in additional FCF.

6. Finalization of CAF II funding which should be announced sometime in Q3. This could provide an incremental $79 million in government funding beginning next year and might even yield a retroactive payment from the government of $60 million this year if completed before September.

7. The transfer of additional assets to CSAL.  As part of the initial spin-off, 75% of Windstream’s network distribution assets were transferred to CSAL. However, Windstream retained assets in certain states which could be transferred at a later date. Based on conversations with management there are enough remaining assets to justify another $100 million rent payment from Windstream to CSAL should these assets eventually be transferred. Assuming the monetization occurs at CSAL's depressed valuation of just under 11x EBITDA, this would represent an opportunity for Windstream to realize another $1.1 billion of value which could be used for further debt reduction. This transaction alone, even without a multiple improvement in CSAL, would yield a $700 million increase to WIN's valuation - an increase of $7 per share - after accounting for the reduction in EBITDA of $100 million at a 4x multiple, and offsetting it by the decrease in debt of 1.1 billion. 

8. The release of a clean set of financial statements making it easy for the average investor to analyze the company’s financial condition and run valuation metrics.